Top Economists Talk Unconventional Fed Policy

The Federal Reserve meets on Monday and Tuesday for a policy-setting session that will include a discussion of unconventional steps the U.S. central bank can take to lift the economy out of recession when official interest rates are already close to zero.

Following are comments from top economists on what the Fed should consider:

FORMER FED VICE CHAIRMAN ALAN BLINDER
The one-word advice to Dustin Hoffman in The Graduate was "plastics." My one-word advice to the Fed now is "spreads." Fortunately, I don't think Ben Bernanke needs this advice. He gets it.

The problem is not that risk-free (or nearly so) interest rates are too high; rather, they are ludicrously low as investors shun risk-taking of any kind. The Fed will soon drop the funds rate to 50 bps, but this will be strictly a feel-good gesture that won't accomplish anything. That's a good thing, too, since with funds at 50 bps and Treasury bills at zero, there's no more ammunition there.
The real problem today is that market interest rates that are built over the Treasury or Fed funds base -- the rates at which real borrowers borrow and real lenders lend -- now range from high to prohibitive. If we are to get credit flowing again, the spreads must come down -- a lot. When the Fed buys commercial paper, guarantees GSE debt, or backs asset-backed securities, it is trying to reduce the spreads on each of these instruments over Fed funds or Treasuries. It should keep doing that.

FORMER IMF CHIEF ECONOMIST SIMON JOHNSON
Consumers and firms around the world are trying to save more. Private demand is still contracting almost everywhere, and this continues to cause widespread insolvency.
In the U.S., monetary policy has responded aggressively and a large fiscal stimulus is in the works, but the financial system remains weak. The real sources of danger are: a) many emerging markets teeter on the brink of default and/or a major currency crisis; and b) serious pressures in vulnerable eurozone countries.

Three main Fed actions can help forestall further damage to the U.S. economy.

1) Interest rates on loans should be lowered through direct Fed action on mortgages and in other markets. Purchases of assets by the Fed should not be sterilized by selling Treasury debt. Inflation is much preferable to deflation.

2) Establish a clear policy on how the U.S. banking system will be recapitalized if needed. The Citigroup bailout is not scalable; there are better ways to protect taxpayer value.
3) As most emerging market debts are in dollars, investors around the world are potentially short of dollars. The Fed can expand its swap lines to more countries both directly and though the IMF. When the IMF is involved, the cost of any default is shared with other countries.

PIMCO CO-CEO MOHAMED EL-ERIAN

(At Reuters Investment Summit)
The Fed has done a tremendous amount of work to stabilize the banking system and restore the commercial paper market. So the situation institutionally is not as bad as it was before. Having said that, it speaks to the simple fact that cutting interest rates is now like pushing on a string; you won't get much impact. So if they go from 100 basis points to 50, as they most likely will, in terms of impact it will be de minimis.
Whether they go to zero or not is complicated, because at zero you declare that the money market industry is basically -- has no model there. So I'm not sure whether they get to zero or not, but the reality is at that these low levels of rates it doesn't matter.

I expect to hear both on monetary policy and on the implementation of what has already been announced in terms of the unorthodox. Whether it comes in the statement or not, I don't have a strong view. They have tended to keep the statement for monetary policy, and refer in general terms to the unorthodox measures, and then use other press releases for the unorthodox.
As to what is next, I think we got a very strong signal from the Federal Reserve and from the speech of Chairman Bernanke (on December 1). Because ... the crisis is now impacting the consumer, there is a desire to stabilize the triple-A consumer finance segment.
So the triple-A asset-backed, Alt-A, credit card, etcetera .. is going to be the next step. Again, you don't want to get there too early. You want to make sure that implementation occurs well. But that is the next step.

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